Debt Ceiling Raised and Default Avoided – But What Next?

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Well they did it, or at least it looks like they will – and I don’t mean England beating India in the second test at Trent Bridge.

No, I mean it looks like the elected representatives on Capitol Hill decided to stop the game of chicken and reach a solution (at least for the time being) to the imminent prospect of the US defaulting on its debts this week.

Not so in Europe, of course. The Greek bailout is a debt default in all but name, but the markets appear to have more or less accepted the fudge that is Europe’s bailout — they would not have accepted a default by the US so lightly. Nor would history, and that was probably on the minds of US lawmakers as they haggled into the night trying to find compromises. Whether it is a great solution or not is less important than the fact that it is a solution. Most importantly, it allows the government to continue to honor its debts.

Failure to do so would have been tragic on a number of levels, not least that the US economy shows some encouraging early signs that it will pick up again next year. As the Telegraph newspaper reported today, data from the St. Louis Fed show that America’s M2 money supply grew at a 6.4 percent annual rate in the second quarter, accelerating to 12.2 percent in June. The compound annual rate of change has exceeded 40 percent over recent weeks. The broader M3 indicator (which includes large savings deposits) is growing at the optimal rate of around 5 percent. The paper reports this has been an uncannily accurate lead indicator over the past five years and bodes well for the economy picking up strongly 6-12 months from now.

In the meantime, we can expect the economy to perform less well, as the Institute for Supply Management’s U.S. manufacturing index for July fell 4.4 percent to a barely positive 50.9 according to Monday’s ISM data release, suggesting a quiet patch in manufacturing during H2 this year.

The timing will be fortunate if the money supply figures truly do herald a recovery in the US. China has been trying to engineer a soft landing of slowing growth by reining in inflation and steering the economy towards more consumption and less investment-led growth. Some fear this week that they may have pushed the pendulum too far as their purchasing managers index dipped below the 50 level, suggesting the slowing may have overshot and contraction is on the way.

Europe is also looking distinctly wobbly; the markets, initially enthusiastic that the Greek bailout would draw a line under further contagion are now not so sure. The Germans, at least, have made it clear they are not willing to fund any more lame ducks and the 440 billion euro EFSF fund is all they are willing to support. Estimates of what would be required if, say, Spain were to follow are closer to 2 trillion euro, so how the markets react over coming weeks will in large part set the confidence levels for the rest of this year.

Europe was doing swimmingly well in 2010, led by manufacturing in particular. As Asian markets have cooled and debt worries have mounted, ISM estimates have declined. While the prospect of a slump in Europe still does not seem likely, a resurgent US would be a welcome development for 2012.

–Stuart Burns

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